ABSTRACT

Estimation of a consistent volatility model of the underlying is crucial for option hedging. The authors illustrate that, compared to the implied/constant volatility method, a local volatility function method can estimate the underlying volatility from option prices more consistently. The result is more accurate hedge parameters and smaller hedging errors. The evidence provided includes an example where the underlying follows an absolute diffusion process, data from both the S&P 500 Index option market, and the S&P 500 futures option market.